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As Oil Explodes, Why Natural Gas Prices Stay Low

If Best Buy had a big sale on Blu-ray discs, would you go out and buy a
Blu-ray player? The energy markets are kind of like that  natural gas is
really cheap, for now, but does that does mean we should build
infrastructure for a natural gas-fueled economy?

Bargains only last so long, even in this recession. Sorry, T. Boone
Pickens.

To delve deeper, let’s examine why gas prices have deflated so much:
Natural gas prices and oil prices are no longer bedfellows in our present
economy. As crude oil has skyrocketed from about $30 per barrel in December
2008 to over $70, natural gas has plummeted from nearly $6 per million BTU
to under $3, recently setting a seven-year low. To put these numbers in
perspective, this makes oil over four times as expensive as natural gas to
produce the same amount of energy, according to the U.S. government’s Energy
Information Administration .

Long story short, this year we are going to have more natural gas than we
need  or potentially even store.

That’s no reason to party. Here’s why: Unlike the global crude oil market,
the natural gas market is incredibly localized. The United States produces
nearly 90% of what it consumes, and the rest is imported from Canada or from
overseas  the latterd amounting to only about 2.5% of U.S. consumption. Thus,
a glut of domestic gas doesn’t really affect imports.

Nor can we quickly expand gas consumption. At this stage, anyone who can use
natural gas instead of crude oil is already burning gas, as the price goes
lower still. There is really only one other form of energy natural gas will
replace  coal. Yes, in some geographical areas, it is currently cheaper to
use natural gas than coal. Shocking, right

So demand for gas, despite its low price, stays relatively low. Then layer
on the effects of the recession: Gas-intensive industrial production is down
12.8% since this time last year, according to Barclays Capital bank
estimates. On top of that, there’s weather: This has been a cool summer in
much of the United States, so less natural gas has been burned for
electricity to power air conditioning than in recent years.

On the supply side, gas output from drilling has been much greater than
anticipated, leading to a surplus that has deflated prices. This in turn has
made many drilling operations unprofitable. The number of natural gas rigs
operating in the United States has fallen by well over 50% over the past
year, based on government EIA data. Because a given well’s output decreases
over time, producers need to drill new wells continually in order to keep up
production. Thus, the falling rig count raises concern about the
longer-term supply outlook.

For now, though, there is abundant gas and limited capacity for storage.
The United States is on track to store 3.8 to 4.0 trillion cubic feet this
year. The contiguous United States have never put more than 3.6 trillion
cubic feet of gas in storage.

Take no comfort in that excess. Unlike crude, we cannot store natural gas
just anywhere we want; we also cannot transport it very easily. Gas is
typically stored in underground reservoirs. The pressure of the gas and the
type of reservoir can make injection and extraction cycles difficult and
lengthy processes. Until traders see extra storage realized, the natural gas
market will be priced in steep contango, in which prices of natural gas for
future delivery hang far above the current price. The low prices now
represent the abundance of unusable and potentially unstoreable gas, a
situation which will not last.

Producers who cannot sell or store their gas will have limited options: cap
their wells  which could be bad for them long-term; give gas away for free
 which has happened before when producers do not want to halt production;
or flare it  burn it off into the atmosphere. With production decreasing
due to low price incentives, and a great deal of gas likely lost from
capping wells and flaring gas, the over-supply will not last, and the price
will be pushed higher by supply and demand fundamentals. The natural gas
futures traded on the New York Mercantile Exchange imply that
natural gas prices will more than double in the next year.

Just as in the case of crude oil, supply and demand do not paint the full
picture. As of August 24, the United States Natural Gas Fund, an
exchange-traded fund listed as UNG on the NYSE, held about 10% of the
contracts in the October 2009 futures market traded on NYMEX. Combine that
position with its over-the-counter swap holdings and UNG held the equivalent
of over 50% of the October contract’s open interest. In following its plan
to buy and hold natural gas, UNG keeps rolling its position into the next
futures month. In other words, every month, UNG sells its enormous long
position in the front month  representing the price of natural gas closest
to the present  and buys back as much as it can in the next contract month.
The idea is that UNG is always trading the most liquid natural gas contract,
but the problem is that UNG has become too large for the market  and for
its own good. In a bear natural gas market, UNG’s massive monthly gas
selloff accelerates the fund’s losses and brings down the price of natural
gas with it.

UNG’s equivalent position in the October futures contract amounts to over a
trillion cubic feet of gas. Given that the United States consumes an
average of about two trillion cubic feet of gas per month, UNG’s position in
the front month  at over half of that month’s consumption  seems too large
for a purely speculative fund.

A great pricing inefficiency arises because this natural gas speculator is
following a pre-defined plan  and the plan is publicly known. Plus, it’s a
foolish one. A fund that invests in long-term natural gas prices is taking
needless risk in placing significant money in the short-term futures market.

What’s next for natural gas Most likely, more weird volatility. As UNG
continues to roll month to month, the front month will continue to get
pounded down. The markets will not hit a true support on the bottom until
traders know for sure how much storage the United States can actually
handle. Whatever happens, this will be a volatile time for natural gas, as
traders battle out prices amidst uncertainty of true storage capacity.

One thing is for sure: UNG is too big to succeed. And the government is in
the business of bailing out only financial institutions that inflate energy
prices  not those that lower them.